🚨 Economic Stimulus Dilemma: Supplementary Budget vs Interest Rates, Effectiveness of Government Economic Policies and Fiscal Soundness Controversy

Today Korean Economic News | 2025.04.21

📌 Supplementary Budget or Interest Rates... Government Caught in Economic Stimulus Dilemma

💬 As the government's 12.2 trillion won supplementary budget is expected to raise the economic growth rate by only 0.1 percentage point, controversy over its effectiveness is growing. While the National Assembly is demanding an increase in the supplementary budget, issuing additional government bonds to fund it could lead to higher market interest rates and deteriorating fiscal soundness, deepening the policy dilemma. The Bank of Korea is not ruling out the possibility of stimulating the economy through a key interest rate cut, but is taking a cautious stance considering inflation concerns and exchange rate volatility.

1️⃣ Easy to Understand

The government and National Assembly are contemplating methods to revitalize the economy. Amid concerns that the current supplementary budget's effect will be minimal, controversy is growing over which policy would be more effective.

The government has drawn up a 12.2 trillion won supplementary budget to stimulate the economy. This money is mainly intended to support small business owners and vulnerable groups struggling due to COVID-19, the Russia-Ukraine war, and US-China trade conflicts, as well as to assist export companies.

However, major economic research institutions such as the Korea Development Institute (KDI) and the Bank of Korea project that a supplementary budget of this size will only raise the economic growth rate by 0.1 percentage point. Some experts argue that "a supplementary budget of at least 20 trillion won is needed."

On the other hand, issuing more government bonds for a larger supplementary budget could cause two problems. First, as the supply of government bonds in the market increases, government bond interest rates will rise, which could lead to higher loan interest rates for businesses and households. Second, government debt would increase, potentially worsening fiscal soundness.

The Bank of Korea could also stimulate the economy by lowering the key interest rate. The current key rate is 3.25%, and lowering it would reduce market lending rates, potentially increasing consumption and investment. However, if the interest rate gap with the United States widens, foreign investment funds could flow out, causing the Korean won to depreciate, which could increase import prices and inflation risk.

In this way, the government and the Bank of Korea are struggling to find a balance between economic stimulus, financial stability, and fiscal soundness. Policies that lean too far in one direction could cause other problems, requiring a cautious approach.

2️⃣ Economic Terms

📕 Supplementary Budget

A supplementary budget is an additional budget drawn up in addition to the already planned and confirmed budget.

• It is drawn up in cases of economic crisis, natural disasters, or urgent fiscal needs, and is finalized after deliberation and approval by the National Assembly.
• It is used as a tool for expansionary fiscal policy during economic downturns to promote economic revitalization.

📕 Key Interest Rate

The key interest rate is the benchmark rate applied when the Bank of Korea lends funds to financial institutions.

• It directly affects deposit and loan interest rates at commercial banks.
• It is generally raised during economic overheating and lowered during economic recession.

📕 Fiscal Soundness

Fiscal soundness refers to how healthy a country's fiscal status is.

• It is mainly measured by the national debt ratio (national debt size relative to GDP).
• Excessive national debt can increase the burden on future generations and lower a country's credit rating.

📕 Government Bond Yield

The government bond yield is the interest rate paid on government bonds issued to borrow funds.

• It is determined by market supply and demand and is influenced by national creditworthiness and economic outlook.
• Government bond yields serve as a benchmark for private loan interest rates and affect the entire financial market.

3️⃣ Principles and Economic Outlook

💡 Effects and Limitations of the Supplementary Budget

• Let's examine the economic effects and practical limitations of the supplementary budget.

  • First, the economic effect of the supplementary budget varies depending on its size, timing, and composition. A supplementary budget is a policy where the government injects additional money into the market to stimulate the economy. Theoretically, increased government spending contributes to economic growth through a "multiplier effect," where production and consumption increase, leading to increased employment and income. However, the actual effect is determined by various factors. First, the size must be sufficient. The current 12 trillion won supplementary budget represents only about 0.5% of annual GDP, and is expected to raise the growth rate by only 0.1 percentage point. Timing is also important; if implemented too late, it could cause economic overheating as the recovery phase approaches. The composition of the supplementary budget is also crucial, as infrastructure investment or R&D support that builds long-term growth engines may have a greater multiplier effect than immediate cash support for consumption.

  • Second, the supplementary budget requires balance with fiscal soundness. Resources for the supplementary budget are mainly secured through government bond issuance. However, expanding government bond issuance leads to increased national debt, which can worsen long-term fiscal soundness. Korea's national debt is about 55% of GDP as of 2025, which is lower than the OECD average (about 110%) but is rapidly increasing. Considering increased welfare spending due to aging, low-growth trends, and other factors, fiscal capacity is gradually decreasing. The International Monetary Fund (IMF) and credit rating agencies have expressed concerns about Korea's fiscal soundness, and excessive government bond issuance could lead to a downgrade in the country's credit rating. Additionally, increased government bond issuance could cause a "crowding-out effect," reducing private investment.

  • Third, various policy combinations are needed along with the supplementary budget. The supplementary budget alone has limitations in economic recovery, making combinations with monetary policy, regulatory reform, and other policies important. The Bank of Korea's key interest rate cut could lower loan interest rates, increasing business investment and household consumption. However, a cautious approach is needed as an increased interest rate gap with the United States could risk foreign capital outflow and exchange rate increases. Structural reforms such as regulatory reform to stimulate private investment, enhanced labor market flexibility, and fostering new growth industries should also be pursued. Investment in future growth engines such as digital transformation, eco-friendly energy, and biohealth is particularly important. The government should pursue tax benefits, financial support, and regulatory easing to induce private investment in these areas.

• While a supplementary budget can be expected to have a short-term stimulating effect during an economic downturn, the currently planned scale is expected to have limited effects. Wisdom is needed to achieve both economic recovery and enhanced growth potential through effective spending composition and various policy combinations, while considering balance with fiscal soundness.

💡 Influence of Interest Rates and Monetary Policy

• Let's analyze the impact of interest rate policy on the economy and the policy dilemma in the current situation.

  • First, interest rates have a wide-ranging impact on the overall economy. The key rate set by the Bank of Korea directly affects deposit and loan interest rates at commercial banks. When interest rates fall, businesses can finance more cheaply, increasing investment, while households see reduced mortgage and credit loan burdens, potentially increasing consumption. Low interest rates also have an "asset effect" that increases consumption by raising the prices of assets like stocks and real estate. Conversely, when interest rates rise, increased loan costs can suppress investment and consumption, and asset prices may fall. Korea's current key rate is 3.25%, having been raised to respond to inflation after COVID-19. Many economic experts believe an interest rate cut is necessary for economic stimulus, but the situation requires consideration of the interest rate gap with the U.S. Federal Reserve.

  • Second, interest rate policy has international constraints. In an open economy like Korea's, independent interest rate policy is difficult. Particularly, if the interest rate gap with the United States widens, foreign investment funds could flow out, causing the Korean won to depreciate, which could lead to increased import prices and inflationary pressure. The current U.S. federal funds rate is 5.0-5.25%, about 2 percentage points higher than Korea's. The Fed is expected to maintain its rate until inflation approaches its target (2%), limiting the Bank of Korea's room for interest rate cuts. Additionally, if foreign exchange market instability increases, there are risks of foreign capital outflow, increased corporate overseas borrowing costs, and increased household foreign debt repayment burdens. Korea, with its high external dependency, is particularly susceptible to economic shocks from exchange rate fluctuations.

  • Third, the effect of interest rate policy in the current situation may be limited. For an interest rate cut to be effective in stimulating the economy, several conditions must be met. First, household and corporate debt levels should be appropriate. Currently, Korea's household debt is about 104% of GDP, far exceeding the OECD average, limiting the capacity for additional loans through interest rate cuts. Also, for the effects of interest rate cuts to be smoothly transmitted to the real economy, the financial system must be stable. With recent real estate market slumps and liquidity crises in some vulnerable companies, financial institutions' risk management has been strengthened, and even with lower interest rates, loan screening might remain strict. Most importantly, if there are fundamental structural problems (low growth, low birth rate, aging population, etc.), interest rate cuts alone cannot be expected to sustain economic revitalization. Therefore, a combination of interest rate policy with structural reform and fiscal policy is important.

• While interest rate policy is an important means of economic revitalization, Korea currently has limited policy operation scope due to interest rate gaps with the United States, high household debt, and inflation concerns. In this situation, it is important to find a balance between financial stability and economic stimulus by carefully adjusting the timing and speed of interest rate cuts.

💡 Optimal Policy Mix for Economic Stimulus

• Let's explore the optimal policy mix that considers economic stimulus, financial stability, and fiscal soundness.

  • First, a balanced pursuit of short-term economic stimulation and long-term growth foundation building is needed. A dual approach is required to respond to the current economic downturn while securing future growth engines. In the short term, support for vulnerable groups and struggling industries is needed to prevent a sharp economic decline. This includes support for small business loans, income preservation for vulnerable groups, and job maintenance support. Simultaneously, investment in future growth engines such as digital transformation, eco-friendly energy, and biohealth should be expanded. Regulatory reform, tax benefits, and infrastructure construction to induce private investment are particularly important. For the supplementary budget, it is more effective to place greater emphasis on productive investments that enhance growth potential rather than simple consumption expenditures.

  • Second, harmonious operation of fiscal and monetary policies is necessary. Fiscal and monetary policies complement each other, and synergy effects are maximized when their directions align. In the current situation, the Bank of Korea needs to pursue economic stimulus through gradual interest rate cuts, while the government needs to adjust policies to increase fiscal spending efficiency. For example, the Bank of Korea can pursue moderate interest rate cuts considering the interest rate gap with the United States and inflation, while the government can focus on the composition and execution speed of the supplementary budget rather than its size. Investing in high multiplier effect areas (R&D, infrastructure, education, etc.) and minimizing fiscal leakage is particularly important. Government policies that induce private investment (e.g., regulatory sandboxes, public-private partnerships) can also enhance the effectiveness of fiscal spending.

  • Third, enhancing growth potential through structural reform is the fundamental solution. Short-term economic stimulus measures alone cannot reverse Korea's low-growth trend. In the long term, structural reforms across the economy, including labor market, education, regulation, and industrial structure, are needed. For the labor market, a "flexicurity" model that eases rigidity while strengthening social safety nets is needed. In education, educational innovation for nurturing talent for future industries is important. Regarding regulations, unnecessary regulations that hinder new industry development should be boldly abolished, transitioning to a negative regulatory system. Structurally, balanced development of manufacturing and service industries, strengthened cooperation between large and small businesses, and accelerated digital and green transition are needed. While these structural reforms may involve short-term pain, they enhance growth potential in the long term and enable sustainable development.

• The optimal policy mix for economic stimulus is to balance short-term economic measures with long-term growth foundation building, maximize synergy effects through harmonious operation of fiscal and monetary policies, and fundamentally focus on enhancing growth potential through structural reform. This multi-layered approach can overcome the current economic downturn and lead to a new leap for the Korean economy.

4️⃣ In Conclusion

Amid domestic and international challenges facing the Korean economy, the government and the Bank of Korea are struggling to find the optimal policy mix balancing economic stimulus, financial stability, and fiscal soundness. The government's 12 trillion won supplementary budget is expected to raise the economic growth rate by only 0.1 percentage point, raising concerns about its effectiveness. However, issuing government bonds to expand the supplementary budget could have side effects such as rising market interest rates and worsening fiscal soundness.

The Bank of Korea is considering a key interest rate cut for economic stimulus, but needs a cautious approach considering the risk of foreign fund outflows, exchange rate instability, and resulting inflation risk due to widening interest rate gaps with the United States. Korea's high household debt level and externally dependent economic structure are factors that must consider both the effects and side effects of interest rate policy.

The optimal policy mix for economic stimulus is to balance short-term economic measures with long-term growth foundation building. The supplementary budget should focus on enhancing future growth engines rather than simple consumption expenditures, and the Bank of Korea should pursue gradual interest rate cuts considering financial stability. Above all, strengthening the economic constitution through regulatory reform, enhancing labor market flexibility, and fostering new industries is important in the long term.

Ultimately, to achieve a balanced attainment of the three goals—economic stimulus, financial stability, and fiscal soundness—harmonious operation of fiscal and monetary policies, along with simultaneous structural reform, is needed. Rather than relying solely on short-term stimulus measures, the true solution lies in strengthening the Korean economy's constitution and securing new growth engines from a mid-to-long-term perspective.